Pensions crisis
Encyclopedia
The pensions crisis is a predicted difficulty in paying for corporate, state and federal pensions in the U.S. and Europe, due to a difference between pension obligations and the resources set aside to fund them. Shifting demographics are causing a lower ratio of workers per retiree, while retirees are living longer. There is significant debate regarding the magnitude and importance of the problem, as well as the solutions.
For example, as of 2008 U.S. states had underfunded their pension programs by an estimated $1 trillion. The present value
of unfunded obligations under Social Security
as of August 2010 was approximately $5.4 trillion. In other words, this amount would have to be set aside today such that the principal and interest would cover the program's shortfall between tax revenues and payouts over the next 75 years.
Reform ideas are in three primary categories: a) Addressing the worker-retiree ratio, via raising the retirement age, employment policy and immigration policy; b) Reducing obligations via shifting from defined benefit to defined contribution pension types and reducing future payment amounts; and c) Increasing resources to fund pensions via increasing contribution rates and raising taxes.
coupled with a fixed retirement age, and a decrease in the fertility rate. Increased life expectancy (with fixed retirement age) increases the number of retirees at any time, since individuals are retired for a longer fraction of their lives, while decreases in the fertility rate decrease the number of workers.
In 1950, there were 7.2 people aged 20-64 for every person of 65 or over in the OECD countries. By 1980, the support ratio dropped to 5.1 and by 2010 it was 4.1. It is projected to reach just 2.1 by 2050. The average ratio for the EU was 3.5 in 2010 and is projected to reach 1.8 by 2050. Examples of support ratios for selected countries in 1970, 2010, and projected for 2050:
using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. One area of contention relates to the expected investment return rate. If this rate (expressed as a percentage) is increased, relatively lower contributions are demanded of those paying into the system. Critics have argued that investment return percentage rate assumptions are artificially inflated, to reduce the required contribution amounts by individuals and governments paying into the pension system. For example, the U.S. stock market (adjusted for inflation) did not have a sustained increase in value between 2000 and 2010. However, many pensions have annual investment return assumptions or estimates in the 7-8% range, which are closer to the pre-2000 average return. If these rates were lowered 1-2 percentage points, the required pension contributions taken from salaries or via taxation would increase dramatically. By one estimate, each 1 point reduction means 10% more in contributions. For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Attempting to sustain better-than-market returns can also cause portfolio managers to take on more risk.
The present value
of unfunded obligations under Social Security as of August 2010 was approximately $5.4 trillion. In other words, this amount would have to be set aside today such that the principal and interest would cover the shortfall over the next 75 years. The Social Security Administration projects that an increase in payroll taxes equivalent to 1.9% of the payroll tax base or 0.7% of GDP would be necessary to put the Social Security program in fiscal balance for the next 75 years. Over an infinite time horizon, these shortfalls average 3.4% of the payroll tax base and 1.2% of GDP.
The Center on Budget and Policy Priorities
(CBPP) reported in January 2011 that:
The pension replacement rate, or percentage of a worker’s pre-retirement income that the pension replaces, varies widely from state to state. It bears little correlation to the percentage of state workers who are covered by a collective bargaining agreement. For example, the replacement rate in Missouri is 55.4%, while in New York it is 77.1%. In Colorado, replacement rates are higher but these employees are barred from participating in Social Security.
The Congressional Budget Office
reported in May 2011 that "...most state and local pension plans probably will have sufficient assets, earnings, and contributions to pay scheduled benefits for a number of years and thus will not need to address their funding shortfalls immediately. But they will probably have to do so eventually, and the longer they wait, the larger those shortfalls could become. Most of the additional funding needed to cover pension liabilities is likely to take the form of higher government contributions and therefore will require higher taxes or reduced government services for residents."
Proposed solutions to the pensions crisis include ones that address the dependency ratio
– later retirement, part-time work by the aged, encouraging higher birth rates, or immigration of working aged persons – and ones that take the dependency ratio as given and address the finances – higher taxes, reductions in benefits, or the encouragement or reform of private saving.
In the U.S., since 1979 there has been a significant shift away from defined benefit plans with a corresponding increase in defined contribution plans, like the 401k. In 1979, 62% of private sector employees with pension plans of some type were covered by defined benefit plans, with about 17% covered by defined contribution plans. By 2009, these had reversed to approximately 7% and 68%, respectively. As of 2011, governments were beginning to follow the private sector in this regard.
Research indicates that employees save more if they are automatically enrolled in savings plans (i.e., enrolled and given an option to drop out, as opposed to being required to take action to opt into the plan). Some countries have laws that require employers to opt employees into defined contribution plans.
are often able to unlock considerable housing wealth
and make returns from other investment
s or employment
.
In more detail: as a result of the demographic transition
from "short-lived, high birth-rate" society to "long-lived, low birth-rate" society, there is a demographic window
when an unusually high portion of the population is working age, because first death rate decreases, which increases the working age population, then birth rate decreases, reducing the youth dependency ratio, and only then does the aged population grow. The decreased death rate having little effect initially on the population of the aged (say, 60+) because there are relatively few near-aged (say, 50–60) who benefit from the fall in death rate, and significantly more near-working age (say, 10–20) who do. Once the aged population grows, the dependency ratio returns to approximately the same level it was prior to the transition.
Thus, by this argument, there is no pensions crisis, just the end of a temporary golden age, and added costs in pensions are recovered by savings in paying for youth.
However, if a country's fertility rate falls too far below replacement level, in future there will be unusually few workers supporting the still large retiree population, and the dependency ratio will rise above historical levels, possibly causing an actual crisis.
A complicating factor is that support for the youth and support for the aged may be provided by different agents, funded in different ways, making the hand off difficult. For example in the United States, care for the youth is provided by parents, with the primary government expense being education, which is primarily provided by local and state governments, paid for by property tax
es (a form of wealth tax
), while care for the aged is commonly provided by hospitals and nursing homes, and the expenses are pensions and health care, which are provided by the federal government, paid for by payroll tax
es (a form of income tax
). Thus, local property taxes and the untaxed labor of parents cannot be directly handed off to fund pensions and health care, creating a coordination problem.
(Stage 1 and 2), the base (youth) is wide, and the peak (aged) is short and narrow. As the population ages, it passes through the demographic window (not pictured) where the pyramid is almost vertical from youth through working age, then tapers in the aged. Once the population has passed through the window and stabilized (Stage 3), youth is less significant (because much slower taper, so a smaller fraction), but aged are more significant (because taller and wider) – however, the overall dependency ratio is roughly the same in both cases.
If, however, the birthrate falls below replacement level, then the bottom shrinks, and as this baby bust works up the pyramid, a narrower base of workers supports a still-large peak of aged, and the dependency ratio does increase; this is particularly the case if there is a sharp (sudden, significant) drop in fertility rate.
For example, as of 2008 U.S. states had underfunded their pension programs by an estimated $1 trillion. The present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of unfunded obligations under Social Security
Social Security debate (United States)
This article concerns proposals to change the Social Security system in the United States. Social Security is a social insurance program officially called "Old-Age, Survivors, and Disability Insurance" , in reference to its three components. It is primarily funded through a dedicated payroll tax...
as of August 2010 was approximately $5.4 trillion. In other words, this amount would have to be set aside today such that the principal and interest would cover the program's shortfall between tax revenues and payouts over the next 75 years.
Reform ideas are in three primary categories: a) Addressing the worker-retiree ratio, via raising the retirement age, employment policy and immigration policy; b) Reducing obligations via shifting from defined benefit to defined contribution pension types and reducing future payment amounts; and c) Increasing resources to fund pensions via increasing contribution rates and raising taxes.
Background
The ratio of workers to pensioners (the "support ratio") is declining in much of the developed world. This is due to two demographic factors: increased life expectancyLife expectancy
Life expectancy is the expected number of years of life remaining at a given age. It is denoted by ex, which means the average number of subsequent years of life for someone now aged x, according to a particular mortality experience...
coupled with a fixed retirement age, and a decrease in the fertility rate. Increased life expectancy (with fixed retirement age) increases the number of retirees at any time, since individuals are retired for a longer fraction of their lives, while decreases in the fertility rate decrease the number of workers.
In 1950, there were 7.2 people aged 20-64 for every person of 65 or over in the OECD countries. By 1980, the support ratio dropped to 5.1 and by 2010 it was 4.1. It is projected to reach just 2.1 by 2050. The average ratio for the EU was 3.5 in 2010 and is projected to reach 1.8 by 2050. Examples of support ratios for selected countries in 1970, 2010, and projected for 2050:
- US: 5.3 / 4.5 / 2.6
- Japan: 8.5 / 2.6 / 1.2
- Britain: 4.3 / 3.6 / 2.4
- Germany: 4.1 / 3.0 / 1.6
- France: 4.2 / 3.5 / 1.9
- Netherlands: 5.3 / 4.0 / 2.1
Pension computations
Pension computations are often performed by actuariesActuary
An actuary is a business professional who deals with the financial impact of risk and uncertainty. Actuaries provide expert assessments of financial security systems, with a focus on their complexity, their mathematics, and their mechanisms ....
using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. One area of contention relates to the expected investment return rate. If this rate (expressed as a percentage) is increased, relatively lower contributions are demanded of those paying into the system. Critics have argued that investment return percentage rate assumptions are artificially inflated, to reduce the required contribution amounts by individuals and governments paying into the pension system. For example, the U.S. stock market (adjusted for inflation) did not have a sustained increase in value between 2000 and 2010. However, many pensions have annual investment return assumptions or estimates in the 7-8% range, which are closer to the pre-2000 average return. If these rates were lowered 1-2 percentage points, the required pension contributions taken from salaries or via taxation would increase dramatically. By one estimate, each 1 point reduction means 10% more in contributions. For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Attempting to sustain better-than-market returns can also cause portfolio managers to take on more risk.
U.S. Social Security program
The number of U.S. workers per retiree was 5.1 in 1960; this declined to 3.0 in 2009 and is projected to decline to 2.1 by 2030. The number of Social Security program recipients is expected to increase from 44 million in 2010 to 73 million in 2030.The present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of unfunded obligations under Social Security as of August 2010 was approximately $5.4 trillion. In other words, this amount would have to be set aside today such that the principal and interest would cover the shortfall over the next 75 years. The Social Security Administration projects that an increase in payroll taxes equivalent to 1.9% of the payroll tax base or 0.7% of GDP would be necessary to put the Social Security program in fiscal balance for the next 75 years. Over an infinite time horizon, these shortfalls average 3.4% of the payroll tax base and 1.2% of GDP.
U.S. State-level issues
In financial terms, the crisis represents the gap between the amount of promised benefits and the resources set aside to pay for them. For example, many U.S. states have underfunded pensions, meaning the state has not contributed the amount estimated to be necessary to pay future obligations to retired workers. The Pew Center on the States reported in February 2010 that states have underfunded their pensions by nearly $1 trillion as of 2008, representing the gap between the $2.35 trillion states had set aside to pay for employees’ retirement benefits and the $3.35 trillion price tag of those promises.The Center on Budget and Policy Priorities
Center on Budget and Policy Priorities
The Center on Budget and Policy Priorities is a non-profit think tank that describes itself as a "policy organization ... working at the federal and state levels on fiscal policy and public programs that affect low- and moderate-income families and individuals."The Center examines the short- and...
(CBPP) reported in January 2011 that:
- As of 2010, the state pension shortfall ranges between $700 billion and $3 trillion, depending on the discount rateDiscount rateThe discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
used to value the future obligations. The $700 billion figure is based on using a discount rate in the 8% range representative of historical pension fund investment returns, while the $3 trillion represents a discount rate in the 5% range representative of historical Treasury bond ("risk-free") yields. - This shortfall emerged after the year 2000, substantially due to tax revenue declines from two recessions.
- States contribute approximately 3.8% of their operating budgets to their pension programs on average. This would have to be raised to 5.0% to cover the $700 billion shortfall and around 9.0% to cover the $3 trillion shortfall.
- Certain states (e.g., Illinois, California, and New Jersey) have significantly underfunded their pension plans and would have to raise contributions towards 7-9% of their operating budgets, even under the more aggressive 8% discount rate assumption.
- States have significant time before the pension assets are exhausted. Sufficient funds are present already to pay obligations for the next 15-20 years, as many began funding their pensions back in the 1970's. The CBPP estimates that states have up to 30 years to address their pension shortfalls.
- States accumulated more than $3 trillion in assets between 1980 and 2007 and there is reason to assume they can and will do that again, as the economy recovers.
- Nearly all debt issued by a state (generally via bonds) is used to fund its capital budget, not its operating budget. Capital budgets are used for infrastructure like roads, bridges and schools. Operating budgets pay pensions, salaries, rent, etc. So state debt levels related to bond issuance and the funding of pension obligations have substantially remained separate issues up to this point.
- State debt levels have ranged between 12% and 18% of GDP between 1979 and 2009. During the second quarter of 2010, the debt level was 16.7%.
- State interest expenses remains a "modest" 4%-5% of all state/local spending.
- Pension promises are contractually binding. In many states, constitutional amendments are also required to modify them.
The pension replacement rate, or percentage of a worker’s pre-retirement income that the pension replaces, varies widely from state to state. It bears little correlation to the percentage of state workers who are covered by a collective bargaining agreement. For example, the replacement rate in Missouri is 55.4%, while in New York it is 77.1%. In Colorado, replacement rates are higher but these employees are barred from participating in Social Security.
The Congressional Budget Office
Congressional Budget Office
The Congressional Budget Office is a federal agency within the legislative branch of the United States government that provides economic data to Congress....
reported in May 2011 that "...most state and local pension plans probably will have sufficient assets, earnings, and contributions to pay scheduled benefits for a number of years and thus will not need to address their funding shortfalls immediately. But they will probably have to do so eventually, and the longer they wait, the larger those shortfalls could become. Most of the additional funding needed to cover pension liabilities is likely to take the form of higher government contributions and therefore will require higher taxes or reduced government services for residents."
Solutions
Reform ideas are in three primary categories: a) Addressing the worker-retiree ratio, via raising the retirement age, employment policy, and immigration policy; b) Reducing obligations via shifting from defined benefit to defined contribution pension types and reducing future payment amounts; and c) Increasing resources to fund pensions via increasing contribution rates and raising taxes.Proposed solutions to the pensions crisis include ones that address the dependency ratio
Dependency ratio
In economics and geography the dependency ratio is an age-population ratio of those typically not in the labor force and those typically in the labor force...
– later retirement, part-time work by the aged, encouraging higher birth rates, or immigration of working aged persons – and ones that take the dependency ratio as given and address the finances – higher taxes, reductions in benefits, or the encouragement or reform of private saving.
In the U.S., since 1979 there has been a significant shift away from defined benefit plans with a corresponding increase in defined contribution plans, like the 401k. In 1979, 62% of private sector employees with pension plans of some type were covered by defined benefit plans, with about 17% covered by defined contribution plans. By 2009, these had reversed to approximately 7% and 68%, respectively. As of 2011, governments were beginning to follow the private sector in this regard.
Research indicates that employees save more if they are automatically enrolled in savings plans (i.e., enrolled and given an option to drop out, as opposed to being required to take action to opt into the plan). Some countries have laws that require employers to opt employees into defined contribution plans.
Other sources of income
Some claim that the pensions crisis does not exist or is overstated, as pensioners in developed countries faced with population ageingPopulation ageing
Population ageing or population aging occurs when the median age of a country or region rises. This happens because of rising life expectancy or declining birth rates. Excepting 18 countries termed 'demographic outliers' by the UN) this process is taking place in every country and region across...
are often able to unlock considerable housing wealth
Reverse mortgage
A remortgage is a form of equity release available in the United States. It is a loan available to seniors aged 62 or older, under a Federal program administered by HUD. It enables eligible homeowners to access a portion of their equity...
and make returns from other investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
s or employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
.
Demographic transition
Some argue that the crisis is overstated, and for many regions there is no crisis, because the total dependency ratio – composed of aged and youth – is simply returning to long-term norms, but with more aged and fewer youth: looking only at aged dependency ratio is only one half of the coin. The dependency ratio is not increasing significantly, but rather its composition is changing.In more detail: as a result of the demographic transition
Demographic transition
The demographic transition model is the transition from high birth and death rates to low birth and death rates as a country develops from a pre-industrial to an industrialized economic system. The theory is based on an interpretation of demographic history developed in 1929 by the American...
from "short-lived, high birth-rate" society to "long-lived, low birth-rate" society, there is a demographic window
Demographic window
Demographic window is defined to be that period of time in a nation's demographic evolution when the proportion of population of working age group is particularly prominent. This occurs when the demographic architecture of a population becomes younger and the percentage of people able to work...
when an unusually high portion of the population is working age, because first death rate decreases, which increases the working age population, then birth rate decreases, reducing the youth dependency ratio, and only then does the aged population grow. The decreased death rate having little effect initially on the population of the aged (say, 60+) because there are relatively few near-aged (say, 50–60) who benefit from the fall in death rate, and significantly more near-working age (say, 10–20) who do. Once the aged population grows, the dependency ratio returns to approximately the same level it was prior to the transition.
Thus, by this argument, there is no pensions crisis, just the end of a temporary golden age, and added costs in pensions are recovered by savings in paying for youth.
However, if a country's fertility rate falls too far below replacement level, in future there will be unusually few workers supporting the still large retiree population, and the dependency ratio will rise above historical levels, possibly causing an actual crisis.
A complicating factor is that support for the youth and support for the aged may be provided by different agents, funded in different ways, making the hand off difficult. For example in the United States, care for the youth is provided by parents, with the primary government expense being education, which is primarily provided by local and state governments, paid for by property tax
Property tax
A property tax is an ad valorem levy on the value of property that the owner is required to pay. The tax is levied by the governing authority of the jurisdiction in which the property is located; it may be paid to a national government, a federated state or a municipality...
es (a form of wealth tax
Wealth tax
A wealth tax is generally conceived of as a levy based on the aggregate value of all household holdings actually accumulated as purchasing power stock , including owner-occupied housing; cash, bank deposits, money funds, and savings in insurance and pension plans; investment in real estate and...
), while care for the aged is commonly provided by hospitals and nursing homes, and the expenses are pensions and health care, which are provided by the federal government, paid for by payroll tax
Payroll tax
Payroll tax generally refers to two different kinds of similar taxes. The first kind is a tax that employers are required to withhold from employees' wages, also known as withholding tax, pay-as-you-earn tax , or pay-as-you-go tax...
es (a form of income tax
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
). Thus, local property taxes and the untaxed labor of parents cannot be directly handed off to fund pensions and health care, creating a coordination problem.
Visual explanation
Visually, in a classic population pyramidPopulation pyramid
A population pyramid, also called an age structure diagram, is a graphical illustration that shows the distribution of various age groups in a population , which forms the shape of a pyramid when the population is growing...
(Stage 1 and 2), the base (youth) is wide, and the peak (aged) is short and narrow. As the population ages, it passes through the demographic window (not pictured) where the pyramid is almost vertical from youth through working age, then tapers in the aged. Once the population has passed through the window and stabilized (Stage 3), youth is less significant (because much slower taper, so a smaller fraction), but aged are more significant (because taller and wider) – however, the overall dependency ratio is roughly the same in both cases.
If, however, the birthrate falls below replacement level, then the bottom shrinks, and as this baby bust works up the pyramid, a narrower base of workers supports a still-large peak of aged, and the dependency ratio does increase; this is particularly the case if there is a sharp (sudden, significant) drop in fertility rate.
Key terms
- Support ratio: The number of people of working age compared with the number of people beyond retirement age.
- Participation rate: The proportion of the population that is in the labor force.
- Defined benefit: A pension linked to the employee's salary, where the risk falls on the employer to pay a contractual amount.
- Defined contribution: A pension dependent on the amount contributed and related investment performance, where the risk falls mainly on the employee.
See also
- Criticisms of welfareCriticisms of welfareThe notion, and the extent of, the modern welfare state has been criticised on both economic and social grounds, from both the Left and the Right of the political spectrum.- Libertarian & Conservative criticisms :...
- Demographic windowDemographic windowDemographic window is defined to be that period of time in a nation's demographic evolution when the proportion of population of working age group is particularly prominent. This occurs when the demographic architecture of a population becomes younger and the percentage of people able to work...
- Social Security debate (United States)Social Security debate (United States)This article concerns proposals to change the Social Security system in the United States. Social Security is a social insurance program officially called "Old-Age, Survivors, and Disability Insurance" , in reference to its three components. It is primarily funded through a dedicated payroll tax...
- Dependency ratioDependency ratioIn economics and geography the dependency ratio is an age-population ratio of those typically not in the labor force and those typically in the labor force...
- Generational accountingGenerational accountingGenerational accounting is a relatively new method of national accounting for measuring redistribution of lifetime tax burdens across generations from social insurance, including social security and social health insurance...
- PensionPensionIn general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
- Public debt
- Retirement plan
- Social SecuritySocial Security (United States)In the United States, Social Security refers to the federal Old-Age, Survivors, and Disability Insurance program.The original Social Security Act and the current version of the Act, as amended encompass several social welfare and social insurance programs...
- Sub-replacement fertilitySub-replacement fertilitySub-replacement fertility is a total fertility rate that leads to each new generation being less populous than the previous one in a given area. In developed countries sub-replacement fertility is any rate below approximately 2.1 children born per woman, but the threshold can be as high as 3.4...